Financial Statements

References:
Abeleda, N. (2012) Simplified Accounting for Sole Proprietorship, Vol. 1
Valix, C. (2017) Theory of Accounts

Financial Accounting reports prepared by the accountant to inform

Statements stakeholders or users of financial statements about the status of
the business, mainly the financial performance and financial
condition.

Accounting Period Accounting period – the period at the end of which financial
statements are prepared; usually one year.

Calendar year – a 12-month period which ends December 31.

(BIR imposes calendar year for sole proprietorship.)

Fiscal year – a 12-month period which does not end on

December 31. (Can be used by partnerships or corporations,
depending on the nature of the business.)

Components of Financial statements – a set of accounting reports which

Financial includes the following:
Statements
Income statement – summarizes the revenue and expenses of
the business to arrive at profit or loss. This shows the results of
the operations or the financial performance of the business. All
accounts appearing on the income statement are nominal
accounts.

Nominal accounts – temporary accounts that are closed at the

end of the accounting period. Balances are not carried forward to
the next period. The balance is transferred to the equity account.

Statement of Changes in Equity – shows the changes

(increase or decrease) in the equity account. Changes may be
due to additional investment of the owner, withdrawal, net
income earned, or net loss incurred. This statement supplements
the Balance Sheet.

Balance Sheet – shows the assets, liabilities and equity of the

business as of a given date, usually the end of the accounting
period. It shows the financial condition of the business. All
accounts appearing on the balance sheet are real accounts.
 Real accounts – permanent in nature; the balances are carried
forward from period to period.

Cash Flow Statement – shows the sources and uses of the

company’s cash. The cash flow activities are usually classified into
operating, investing and financing.

Classification of Current asset – assets which are expected to be converted into

Assets and cash within one year, or within the trading cycle of the business.
Liabilities
Example: Cash, Accounts Receivable, Inventory, Supplies

Non-current asset – assets which are acquired for use in the

business (usually for longer period, more than one year) and not
intended to be converted into cash.

Example: Land, Building, Machinery, Furniture and Fixture, Office

Equipment, Tools, Delivery Truck

Current liability – liabilities payable within one year.

Example: Short-term note payable, Accounts payable, Accrued

expenses, Unearned income

Non-current liability – liabilities payable beyond one year.

Example: Long-term note payable, Bonds payable, Mortgage

payable

Statement of Operating activities – transactions that affect net income.

Cash Flows
Investing activities – transactions that affect non-operating
current assets and non-current assets.

Financing activities – transactions that affect non-operating

current liabilities and non-current liabilities and owner’s equity.

CA/CL – Operating
NCA – Investing
NCL/Equity - Financing

Two ways of presenting Statement of Cash Flows:

(1) Direct Approach
 (2) Indirect Approach

See illustration on excel file Basic Accounting_01

Note: All cash transactions can be taken from the Cash Ledger.
Adjusting entries Purpose:
• To conform to the principle of “Matching Costs against
Revenue” to have a more accurate measurement of net
income
• To get the correct valuation of assets and liabilities
• To get the correct determination of the equity

Usual adjustments:
• Unused supplies – bought supplies for the year are divided
into used (expense) and unused (asset)

• Prepaid expenses – paid expenses though not all are

utilized; the utilized portion is expensed while the
unutilized portion is set up as asset

• Accrued expenses – incurred but not yet paid

• Unearned income – collected from customer but not yet

delivered

• Accrued income – delivered but not yet collected

• Bad debts – set up for uncollectible portion of receivables

• Depreciation – wear and tear of non-current assets

Unused supplies Unused supplies – bought supplies for the year are divided into
used (expense) and unused (asset)

Example: Bought 10,000 worth of supplies. At the end of the

period, 4,500 remain unused.

Asset Method:
Supplies 10,000
Cash/Accounts Payable 10,000

Supplies Expense 5,500

Supplies 5,500
 Supplies – 4,500 (10,000 – 5,500)
Supplies Expense – 5,500

Expense Method:
Supplies Expense 10,000
Cash/Accounts Payable 10,000

Supplies 4,500
Supplies Expense 4,500

Supplies – 4,500
Supplies Expense – 5,500 (10,000 – 4,500)

Prepaid expenses Prepaid expense – paid expenses though not all are utilized; the
utilized portion is expensed while the unutilized portion is set up
as asset

Example: On October 1, 2018, the business paid one-year rent

amounting to P24,000 (P2,000 per month). Year-end is on
December 31, 2018.

Expense Method: (traditional)

Rent Expense 24,000
Cash 24,000

Prepaid Rent 18,000

Rent Expense 18,000

Rent Expense (3 months) – 6,000 (24,000 -18,000)

Prepaid rent – 18,000

Reversing entry on January 1:

Rent expense 18,000
Prepaid Rent 18,000

Normal entry:
Rent Expense 12,000
Cash/Accounts Payable 12,000

With adjustment on year-end for unused asset. With reversing

entry on the first day of the following accounting period.
 Asset Method:
Prepaid Rent 24,000
Cash 24,000

Rent Expense 6,000

Prepaid Rent 6,000

Rent Expense (3 months) – 6,000

Prepaid Rent – 18,000 (24,000 – 6,000)

Normal entries:
Prepaid Rent 12,000
Cash/Accounts Payable 12,000

Rent Expense 12,000

Prepaid Rent 12,000

With adjustment for every consumption of prepaid asset.

Adjustment on year-end for used asset. No reversing entry.

Accrued expenses Accrued expense – incurred but not yet paid

Example: At the end of December, the following expenses were

incurred but remain unpaid.
Advertising – 5,400
Utilities – 3,250

Entry:
Advertising expense 5,400
Utilities expense 3,250
Accounts payable (or other accounts) 8,650

Unearned income Unearned income – collected from customer but not yet delivered

Example: On December 28, 2018, a customer paid P20,000 for

requested services to be delivered. As of December 31, only
P8,000 worth of services were rendered.

Income Method: (Traditional)

Cash 20,000
Service income 20,000

Service income 12,000

Unearned income 12,000
 Service income – 8,000 (20,000 – 12,000)
Unearned income – 12,000

Reversing entry on January 1:

Unearned income 12,000
Service income 12,000

Normal entry:
Cash 20,000
Service income 20,000

With adjustment at year-end and reversing entry on first day of

the following accounting period.

Liability Method:
Cash 20,000
Unearned income 20,000

Unearned income 8,000

Service income 8,000

Service income – 8,000

Unearned income – 12,000 (20,000 – 8,000)

When earned:
Unearned income 12,000
Service income 12,000

Normal entries:
Cash 20,000
Unearned income 20,000

Unearned income 20,000

Service income 20,000

With adjustment for every setup of liability. Adjustment at year-

end for earned income. No reversing entry on the first day of the
accounting period.

Accrued income Accrued income – delivered but not yet collected

 Example: On December 30, 2018, the company provided service
to a customer and billed the same, amounting to P12,500.

Entry:
Accounts Receivable 12,500
Service Income 12,500

Bad debts Bad debts - set up for uncollectible portion of receivables

Example: Balances before adjustments are as follows:

Sales 205,000
Accounts Receivable 48,000
Allowance for bad debts 1,900

Three methods:
1. Percentage of Sales
The company estimates that 1% of sales is uncollectible.
205,000 x 1% = 2,050
This is the additional amount of allowance for bad debts.

Entry:
Bad debts expense 2,050
Allowance for bad debts 2,050

Balance of allowance for bad debts at year-end:

1,900 + 2,050 = 3,950

2. Percentage of Accounts Receivable

The company estimates that 5% of accounts receivable is
uncollectible.
48,000 x 5% = 2,400
This is the total amount of allowance for bad debts.
The adjustment is 2,400 – 1,900 = 500.

Entry:
Bad debts expense 500
Allowance for bad debts 500

Balance of allowance for bad debts at year-end: 2,400

3. Aging of receivables (discussed in Financial Accounting)

Simplest example:
The accounts receivable amounting to 48,000 is composed of
the following:
 Age of receivable Amount % uncollectible
0-30 days 24,000 2%
31-60 days 15,000 5%
Over 60 days 9,000 8%
The total amount of allowance for bad debts is:
24,000 x 2% = 480
15,000 x 5% = 750
9,000 x 8% = 720
480 + 750 + 720 = 1,950
The adjustment is 1,950 – 1,900 = 50.

Entry:
Bad debts expense 50
Allowance for bad debts 50

The balance of Allowance for bad debts is 1,950.

Depreciation Depreciation – wear and tear of non-current assets

Straight-line method = (Cost of acquisition – salvage value) /

useful life.

Salvage value – the amount that the asset could be sold for at
the end of its useful life.

Useful life – the number of years or period the asset is expected

to be in use for the business.

Example: On January 1, 2018, the company purchased furniture

and fixtures amounting to P20,000. The expected useful life of
the property is five years.

Using the straight-line method of depreciation, the expense for

the year is P4,000. (P20,000 / 5 years = P4,000 per year).

Entry:
Depreciation expense 4,000
Accumulated Dep’n – F&F 4,000

Note: Take note of the date the property was purchased. If it was
purchased during the year, the depreciation should be calculated
for the period it was in use.
 Example: On June 1, 2018, the company purchased furniture and
fixtures amounting to P20,000. The expected useful life of the
property is five years.

From June 1 to December 31, the property was in use for seven
months. Depreciation will be computed as (P20,000/5 years x
7/12 months = 2,333).

Note: Take note of the date. Seriously. June 1 to December 31 is

seven months. June 30 to December 31 is six months.

Accrued Interest Accrued interest expense –

When the business has existing loans, they have to accrue the
interest expense at year-end.

Example: The company has a loan amounting to P100,000, with

interest at 12%. The loan was granted on October 15, 2018.
On December 31, 2018, the accrued interest expense is:
(100,000 x 12% x 2.5/12 months = 2,500)

Entry:
Interest expense 2,500
Interest payable 2,500

Accrued interest income –

When the business extends loans or when they received notes

with clause for interest.

Example: On September 30, the company received a 180-day

note from a customer, amounting to 30,000 at 12% interest.
On December 31, 2018, the accrued interest income is:
(30,000 x 12% x 3/12 months = 900)

Entry:
Interest Receivable 900
Interest Income 900

Interim Financial Interim – a shorter period of time than the usual one year.
Statements
For monitoring purposes, usually internal use of the management,
companies may prepare financial statements on a monthly basis,
 quarterly or semi-annually. These are shorter periods compared
to the annual preparation.

Not required by regulatory agencies. Mostly for management use,

in decision-making.

Worksheet Worksheet – a columnar working paper which will show all the
(Optional) accounts together with their adjusted amounts that will appear in
the financial statements.

The adjusted balances are classified into nominal and real

accounts, which are extended to the Income Statement or
Balance Sheet column.

The worksheet also shows whether the company generated a

profit or incurred a loss.

It will also aid in the preparation of closing entries, post-closing

trial balance, and reversing entries.

See Basic Accounting_01 file for a sample.